2009 - 1st Quarter Market Review and Commentary

The stock market continued to falter in the first quarter of 2009. Slashed earnings estimates, rising unemployment, and confusing government policy all weighed heavily on stocks. The S&P 500 was down another 26% at its nadir before a late quarter rally trimmed the losses to 11.7% at quarter end. The activity was volatile and largely driven by government response to the on-going credit crisis.

The government announced the passage of a $789 billion stimulus bill and a plan to purchase $300 billion of longer-term treasury securities. Investors showed their frustration with the announcements by moving to cash and the safety of government bonds. The lone bright spot in the quarter were treasuries which showed a slight gain due to "flight to safety" and the government’s purchase announcement.

Economically, the news was as expected; which was bad. Unemployment continues to rise as firms cut payrolls and hours in response to weak consumer demand. The weak demand showed up in the GDP data for the fourth quarter which showed a sharp 6.3% decline. Despite the spate of poor economic and market news there are nascent signs of a recovery. There are very early signs that housing sales are starting to pick up materially. The broad decline in housing prices were bound to attract bargain hunters and we may not be at the level. Housing is a crucial component of an economic turn as it still represents the vast majority of an individuals net worth.

The current earnings yield of the S&P 500 is 7.7% and 10yr Treasuries are approximately 2.75%. This spread of 5 % is very large from a historical perspective and suggests equities may very well be undervalued. Historically, the spread is closer to 0%. Obviously this large spread suggests that earnings estimates are still too high and we tend to agree with that opinion. However, even with a material cut in estimates of 30% the spread is still very attractive. The time to sell may well be past and investors need to review their current holdings and strategies.

We find the most attractive segment of the market to be high quality muni-bonds, high quality corporate debt securities, and a diversified portfolio of high yield corporate debt. The muni market is currently yielding about 5% tax-free and presents a tremendous opportunity especially in light of tax increases in the Obama plan. High yield debt securities have many of the same characteristics of equities in the current environment. While there are sure to be an increase in defaults, a well diversified high yield portfolio will weather the storm as equities in general surely will. In the meantime an investor could reap 15%+ in annual income while capturing reasonable upside appreciation if the stock market rebounds. This portfolio, which we have been recommending to our individual accounts since the 2nd quarter 2008, was up slightly during the first quarter.